Regulated Funds In Ireland - A Safe Harbour For Turbulent Times - Fund Management/ REITs

Article by Mark White, Head of Investment Management, McCann FitzGerald

Introduction

The global hedge fund industry is currently focused on finding a means of recovery from the turmoil in the financial markets towards the end of 2008, which saw many leading hedge funds suffer high performance losses and record redemption requests, forcing funds to restrict or suspend redemptions.

The consensus would appear to be that recovery in 2009 will require a fundamental review and revision of the structures and operations of hedge funds as well as where those funds might be domiciled in future.

Across the hedge fund industry in the United States and Europe, including the United Kingdom, the most consistently-forecast development is the introduction of regulation for hedge funds and their managers.

The establishment of a regulated fund in a well-recognised jurisdiction offers considerable benefits to investors, particularly in current market conditions. The objective of this article is to demonstrate how, in the Irish environment, an investment fund may be established which offers regulatory protection to prospective investors without requiring the fund to sacrifice its investment objectives and alternative strategies or its dynamic and flexible structure. This article also explains the significant taxation benefits which are available to investors in an Irish regulated fund.

Benefits Of Irish Regulatory Regime

Ireland has established a highly regarded and well regulated environment which serves a variety of fund types. Ireland offers prudent but practical regulation of both retail and sophisticated funds and this is considered to be one of the key reasons for the success of the funds industry in Ireland.

The Irish Financial Regulator is considered flexible and approachable and receptive to tight deadlines for fund launches.

Many investors who wish to gain exposure to alternative asset classes but do not want to invest in lightly-regulated jurisdictions, such as Cayman or BVI, now appreciate that they can gain exposure to such asset classes by investing in an Irish investment fund authorised by the Irish Financial Regulator (an "Irish Fund"). Furthermore, the investment fund structure is increasingly being used to house other products, such as CDOs and CLOs, which are having difficulty being launched as debt products in the current market environment.

Fund Structure and Service Providers

An Irish Fund may be established as one of a number of legal structures: an investment company, a unit trust, a common contractual fund or an investment limited partnership. Funds are most commonly established in Ireland as either investment companies or unit trusts. A unit trust, for example, is often favoured by fund promoters who are marketing funds to certain categories of Irish, UK, US or Japanese investors. If an investment company is chosen, it will be incorporated in Ireland as a public limited company.

An Irish Fund normally does not itself employ staff, nor does it have offices, but rather has its activities supported by service providers. The primary service providers to an Irish Fund are its investment manager, custodian and administrator. The Financial Regulator requires that both the custodian and administrator are based in Ireland. However, the investment manager does not need to be based in Ireland and, in fact, the vast majority of investment managers would be based outside of Ireland.

The role of the custodian, which is primarily to hold the fund's assets in a secure manner, segregated from its own proprietary assets, offers significant comfort to investors. The Financial Regulator's Notices specifically require the custodian to act in the interests of the unitholders in the funds. The custodian will be directly liable to the unitholders for any unjustifiable failure to perform its obligations or improper performance of them. Such duties will also extend to the custodian's appointment of any sub-custodians, which is of particular importance to investors where assets are likely to be held in various jurisdictions outside Ireland.

Retail Funds and Sophisticated Funds – UCITS and Non-UCITS

A variety of factors influence the choice of fund structure and type.

The most important factors in choosing a fund structure are the profile and location of target investors and the proposed investment policy of the fund. Each of these factors will be extremely important in deciding whether to structure an investment fund under either the UCITS or the non-UCITS regime.

Firstly, to look at the UCITS regime. The term UCITS stands for Undertakings for Collective Investment in Transferable Securities.

UCITS

The principal advantage of a UCITS fund is that, pursuant to the UCITS Directive, once a UCITS is authorised in one EU Member State, it can, through a "passport regime" be sold in other EU Member States (subject to a limited registration process in other relevant Member States) without requiring further authorisation from that Member State in which the fund is to be marketed.

A recent Irish Funds Industry Association (IFIA) survey revealed that UCITS account for 81% of the net assets of Irish-domiciled funds. Given the challenging economic climate, it is reasonable to assume that investors will be looking for a much greater focus on governance, with more emphasis on transparency and risk management, all features which the UCITS regime can offer. The investment diversification limits imposed in the context of a UCITS are now seen, not as inhibiting investment strategies but, in fact, good marketing features. UCITS have effectively become the global brand for retail investment funds around the world and Ireland has established a reputation as an ideal home Member State for well-serviced and well-regulated UCITS.

Not only is the UCITS the most popular fund product throughout the European Union, many UCITS funds are also registered for sale in a number of jurisdictions outside of the European Union. This demonstrates the suitability of UCITS as the ideal global distribution platform and confirms that the UCITS is now recognised as the truly global mutual fund product.

The principal pieces of legislation governing the UCITS regime are the UCITS III Product and Management Company Directives, both of which were transposed into domestic law in Ireland in 2003. Of particular importance is the Product Directive, discussed in more detail below.

The UCITS Product Directive enables UCITS to invest in transferable securities, money market instruments, units of other UCITS III (or similar) funds, deposits and financial derivative instruments (FDI): together, UCITS compliant assets.

Some specific new products have emerged in light of the greater flexibility afforded under the UCITS III. Prior to UCITS III, all of these products would not have been eligible for authorisation as UCITS.

130/30 Funds - Investors are turning to 130/30 funds to combine the investment potential of hedge funds with the perceived traditional strategy of long-only funds. Significant interest in the 130/30 product has been expressed from European-based institutional investors and pension funds. This product constitutes an alternative strategy while retaining the risk management and control processes that are associated with UCITS, thereby affording additional comfort to investors.
Financial Indices – UCITS funds now have the ability to gain exposure to assets such as commodities and hedge funds which cannot be invested in directly by the UCITS. This is achieved by the UCITS entering into one or more derivatives on a hedge fund or commodity index. It must be demonstrated to the satisfaction of the Financial Regulator that the index in question can be categorised as a financial index.
Structured Products – Given the ability of UCITS to use a variety of derivitives for investment purposes, many structured products are now established as UCITS, with the fund entering into a single swap transaction with a finite period, the return on which is based on the performance of one or more financial indices.

Timeline for the Establishment of UCITS III FUND

Non-UCITS Regime

A variety of factors influence the choice of fund structure and type. By contrast, since non- UCITS are established pursuant to domestic Irish law, as opposed to EU law, they do not have an automatic "passport" for sale in other EU Member States. It follows, therefore that the Financial Regulator has more flexibility regarding the imposition or relaxation of conditions generally. In developing its regulatory regime for non-UCITS, the Financial Regulator has drawn a distinction between different categories of investors in terms of level of sophistication (i.e. whether retail or professional). In addition, certain specialist funds which are not permitted under the UCITS rules are permitted as non-UCITS. These would typically be funds which employ more complex investment strategies and, while potentially posing greater risk, they would also potentially offer greater reward.

Qualifying Investor Funds ("QIF")

The QIF, which is confined to sophisticated investors, is the key non-UCITS fund available in Ireland and has proved to be an attractive option for fund promoters, particularly hedge fund managers.

Criteria for Investment

In order to invest in a QIF, an investor must meet the following tests:

a minimum subscription of €250,000 (or equivalent) is required; and
qualifying investor: an individual with net worth (excluding main residence and household goods) of €1.25 million; or an institution which owns or manages at least €25 million or whose beneficial owners are qualifying investors in their own right.

By meeting these criteria, qualifying investors are presumed to have a degree of knowledge and experience of the market to understand, and give informed consent to, the investment risks to which they may be exposed and to be able to withstand loss that might arise from a higher risk strategy.

Investment and Leverage Flexibilty

All investment and borrowing restrictions which normally apply to non-UCITS are automatically disapplied in the case of a QIF. Consequently, a QIF is permitted to:

carry on short selling without restriction;
employ leverage without restriction; and
employ/invest in a wide variety of derivative contracts (including the buying and selling of swaps, CFDs, futures and options) and repurchase, reverse repurchase and stock-lending agreements.

The reason why an Irish QIF is such a popular product is that it can benefit from automatic derogations from the Financial Regulator. In addition, it benefits from a one-day authorisation procedure.

QIF One-day authorisation procedure

In February 2007, the Financial Regulator issued new procedures which allow QIFs to be authorised in one day, provided certain conditions are met. Provided the Financial Regulator receives a complete application for the authorisation of a QIF before 3pm on a particular day, a letter of authorisation for that QIF can be issued on the following business day. A prerequisite to the new procedure being available

in a particular case is that the promoter, investment manager, custodian/trustee, administrator and all of the directors of the QIF must be approved in advance by the Financial Regulator, and this can take some time depending on the status of the promoter and investment manager in particular. The custodian and administrator will invariably be approved already to carry on their business activities.

The investment company or management company, as appropriate, is required to certify that all of the fund documentation complies, in all material respects, with the Financial Regulator's Notices and Guidance Notes. In addition, the custodian/trustee of the QIF must provide a similar confirmation in relation to the provisions of the custodian agreement or trust deed.

This procedure constitutes a step-change for the Irish funds industry and offers an advantage over many other funds jurisdictions. It also offers a good example of how the industry and the Financial Regulator are prepared to respond flexibly and effectively to pressing market issues and in particular to acknowledge that speed to market plays a vital role in the establishment of any fund. It effectively means that the QIF can be established as quickly as Cayman or BVI-based funds. This does not, however, take away from the fact that the fund is located and regulated in an EU Member State.

Timeline for the Establishment of a QIF

Taxation of an Irish Fund

An Irish Fund benefits from what is known as the gross roll-up regime, and so income and gains accumulate within an Irish Fund free from Irish tax. All of the income earned from the investments held by the Irish Fund, such as dividends, interest and rental income, are earned free from income tax. On the disposal of those investments, any gain on the disposal is not liable to capital gains tax.

No Irish stamp, capital or other duties apply on the issue, transfer or redemption of shares/units in an Irish Fund.

An exit tax regime applies to Irish Funds. Under this regime, no withholding tax applies on payments to non-Irish resident investors, and certain Irish resident investors, once certain declarations have been put in place (see further below).

Taxation benefits for non-Irish investors

Provided that an investor has made a declaration to the Irish Fund as to non-Irish residence, the investor would not be subject to Irish withholding tax on payments of income received from, or gains realised on, an investment in the fund.

Ireland is an "onshore" tax and EU-regulated jurisdiction for OECD purposes and consequently the income earned and gains realised by investors in an Irish Fund should not suffer the penal rates of tax imposed by most tax jurisdictions on income that is earned or gains realised by investors in offshore tax jurisdictions such as Jersey, BVI, Cayman etc.

Value Added Tax ("VAT")

The Irish Fund does not charge VAT but VAT may be charged on services provided to the Fund. Several of the services provided to an Irish Fund are exempt services for the purposes of Irish VAT. The principal exemptions relate to discretionary investment management services, administration services (including corporate administration) and marketing services. Custodial services are also generally exempt from Irish VAT. Other services provided to a fund may create a VAT cost. VAT recovery is, however, available to the extent that the Irish Fund has either non-EU assets or non-EU investors.

Treaty access

Ireland is an onshore tax jurisdiction for OECD purposes and, as such, has an extensive network of 50 double taxation agreements (each a "DTA") that have been agreed and a further 14 DTAs which are at various stages of negotiation.

The income and gains derived from the assets of an Irish Fund may suffer withholding tax in the jurisdiction where such income and gains arise. This foreign withholding tax may be reclaimable under a DTA, depending on the terms of the relevant DTA. This foreign withholding tax is likely to be less than the penal rates of withholding tax that generally apply if the payee was located in an offshore tax jurisdiction.

Because of the tax exempt nature of an Irish Fund, a number of Ireland's DTAs, where applied by jurisdictions on a strict basis, are available only to "persons" who are liable to tax in Ireland. Consequently, an Irish Fund may not be such a "person" for the purposes of a DTA unless there are investors in the Irish Fund who come within the scope of Irish tax (namely, Irish tax resident investors). Where a particular tax authority does not regard an Irish Fund as resident in Ireland for the purposes of a DTA, various structures can be used to minimise the effect of this. One structure involves using a "qualifying company" (within the meaning of section 110 of the Taxes Consolidation Act 1997 of Ireland, as amended). This qualifying company would be a wholly-owned subsidiary of the Irish Fund and the assets of the Irish Fund would be held at this subsidiary level. Since the subsidiary company would be a taxable entity, it could avail of the DTA benefits. The qualifying company is a tax neutral vehicle (i.e. it is managed in such a way that it incurs a nominal amount of Irish tax) so there should be no real Irish tax leakage at the level of the qualifying company.

Treaty benefits have been obtained by Irish Funds from a number of Ireland's treaty partners, and each jurisdiction should be reviewed on a case by case basis to determine whether the Irish Fund can avail of the benefits of that particular DTA.

Unlike most DTAs, the Ireland/US DTA specifically includes Irish Funds (with the exception of CCFs) as residents of Ireland for the purposes of the Ireland/ US DTA. However, like other residents in this regard, their entitlement to treaty benefits is subject to a limitation on benefits clause, similar to that provided for in nearly all US DTAs. The Irish Fund, provided certain conditions are met, could benefit from the reduced rates of US withholding tax provided for in the Ireland/US DTA, e.g. a zero per cent withholding tax rate on US interest payments and a 15 per cent withholding tax rate on US dividend payments (in certain limited circumstances the rate may be 5 per cent).

Repayment of debt tax free

Given that a QIF can enter into borrowing arrangements without restriction, it will often have a significant amount of debt. By virtue of the gross rollup regime, a QIF that has significant borrowings could sell an asset and utilise the gross proceeds from that sale to pay down any existing debt within the QIF tax free. The gross proceeds of the disposal are available to the QIF for reinvestment. If one compares this to an ordinary company, where a portion of the disposal proceeds would normally be paid over to the relevant tax authorities to discharge any resultant capital gains tax liability (i.e. would not be available to repay debt or for re-investment), it becomes clear why QIFs are so attractive for highly- leveraged investment strategies.

Amalgamation of Existing Offshore Funds with Irish Funds

Whereas the regulatory and tax benefits of establishing an Irish Fund are apparent, some consideration might also be given as to how an existing offshore fund might be managed more efficiently alongside, or through, a new Irish Fund. For example, it may be possible to amalgamate the existing offshore fund with the new Irish Fund in a tax efficient manner, which would then allow the fund manager to manage a single pool of assets, thereby reducing the costs of operating two funds. The new merged fund would then benefit from the tax and regulatory advantages available to an Irish Fund. Two options that might be considered in this regard are as follows.

Offshore Fund feeding into an Irish Fund

The offshore fund would transfer its assets into the Irish Fund in exchange for units in the Irish Fund. In this way, the existing offshore fund becomes a feeder fund into the Irish master Fund. All assets are now held at the level of the Irish master Fund and the investors in the offshore fund remain as unit holders in that fund.

The transfer by the offshore fund of its assets to an Irish Fund would be exempt from Irish stamp duty. However, depending on the jurisdiction in which the assets are located, the transfer of assets to the Irish Fund may be subject to transfer taxes in that jurisdiction (subject to any reliefs of that jurisdiction that may be available). The corresponding issue of units to the offshore fund in consideration for the transfer of assets would be exempt from Irish stamp duty, as indicated in section previously.

Since the investors in the offshore fund remain invested in the offshore fund, there is no actual exchange or disposal of units by the investors and so the investors should avoid a taxable event.

Exchange of units/Asset transfers

The Irish Fund could acquire the offshore fund by the investors exchanging their units in the offshore fund for units in the Irish Fund either by way of a "paper for paper" exchange or a "share for undertaking" exchange. The result of the exchange would be that, once again, all the assets are held at the level of the Irish Fund but in this case the investors would also transfer to the Irish Fund, rather than remaining invested in the offshore fund. The offshore fund could then be wound up following completion of the exchange.

The transfer by the offshore fund of its assets to the Irish Fund would be exempt from Irish stamp duty.

The corresponding issue of units in the Irish Fund to either the offshore fund or the offshore investors directly would be exempt from Irish stamp duty for the reasons outlined previously.

Again, depending on the location of the offshore fund's assets (and subject to the reliefs available in that location), the transfer by the offshore fund of its assets to the Irish Fund may result in foreign transfer taxes.

The investors (unless Irish resident) would not be subject to Irish tax on income or gains arising to them in connection with their holding of units in the Irish Fund.

From the perspective of the investors, the exchange of units would be considered a 'paper for paper' transaction and consequently from a taxation perspective, in many jurisdictions, the investors would not be obliged to account for tax in respect of this exchange, as the investors would not be deemed to have realised their investment. However, this taxation treatment is dependent on the taxation reliefs available to the investors in their relevant jurisdiction of residence for tax purposes.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

Ireland: Regulated Funds In Ireland - A Safe Harbour For Turbulent Times